CHAPTER – 1

INTRODUCTION
1.1 OVERVIEW
Virtually, everyone who is interested in financial markets seems to agree on
two things: that markets are now more volatile than ever, and that volatility causes
many problems. Volatility is difficult to analyze because it means different things to
different people. People are rarely precise when they talk about volatility. Also, there
is a lot of misinformation about volatility. Volatility is the most basic statistical risk
measure. It can be used to measure the market risk of a single instrument or an entire
portfolio of instruments.
Volatility defined in simple terms refers to variations or fluctuation in the
price of financial assets such as stocks, exchange rates or interest rates over a period
of time. Mullins (2000) defined volatility as: The degree to which the price of a
security, commodity, or market rises or falls within a short-term period.
The most important thing to note about this definition is that it specifically
mentions price increases and decreases. People are usually most concerned about
volatility during periods when prices decrease or go through a “correction”. During an
extreme bull market, no one (with the possible exception of investors with short
positions) seems to care that the markets are exhibiting volatility.
According to Reddy (1996), market is said to be volatile when the prices of
securities or their returns fluctuate widely over a period of time. As opposed to this, in
a stable market, prices tend to follow a smooth course and shift gradually from one
equilibrium point to another, as the information is gradually assimilated into prices.
So, volatility means how drastically the price of an asset tends to rise and fall.
The stock market is considered to be volatile when there is sharp rise and sharp
decline in the markets within a short span of time. Stock return volatility measures the
random variability of the stock returns. Simply put, stock return volatility is the
variation of the stock returns in time (Gangadhar and Reddy, 2009).
While volatility can be expressed in different ways, statistically, the most
commonly used measure of volatility is the standard deviation. It measures the
deviation of current price from its average price over a period of time. Greater this
deviation, greater is the volatility. Therefore, the more volatile stock is harder it is to
estimate its future price. More specifically, it is the standard deviation of daily stock
returns around the mean value and the stock market volatility is the return volatility of
the aggregate market portfolio.
Alan Greenspan, Chairman of the Federal Reserve Board in Washington,
described it as "Irrational Exuberance" at his speech in December 1996. Some have
referred to it as speculative bubble, some baby boom effect, whereas some have
explained it as 'herd behavior'. So what is it that these people are referring to…?
"Volatility" as is called in stock market parlance. This high volatility has given
sleepless nights to a lot of investors as well as market regulators.
To many among the general public, the term ‘volatility’ is simply synonymous
with risk, in their view high volatility is to be deplored, because it means that security
values are not dependable and the capital markets are not functioning as well as they
should. Merton Miller (1991), the winner of the 1990 Nobel Prize in economics,
writes in his book Financial Innovation and Market Volatility …. “By volatility
public seems to mean days when large market movements, particularly down moves,
occur. These precipitous market wide price drops cannot always be traced to a
specific news event. Nor should this lack of smoking gun be seen as in any way
anomalous in market for assets like common stock whose value depends on subjective
judgement about cash flow and resale prices in highly uncertain future. The public
takes a more deterministic view of stock prices; if the market crashes, there must be a
specific reason.”
Volatility can be defined as changeability or randomness of asset prices.
Theoretically, a change in the volatility of either future cash flows or discount rates
causes a change in the volatility of share prices. "Fads" or "bubbles" introduce
additional source of volatility (Schwert, 1989).
Black & Scholes (1973) assumed that financial asset prices are random
variables that are log-normally distributed (A probability distribution in which the log
of the random variable is normally distributed, meaning it conforms to a bell curve).
Therefore, returns to financial assets, the relative price changes are usually measured
by taking the differences between the logarithmic prices. These differences (the so-
called log-relatives) are normally distributed. A normal distribution is indicated by a
bell shaped curve. This is shown in Figure 1.1.
 Figure 1.1: The Bell Shaped Normal Cumulative Distribution
Volatility is defined as the variation or dispersion or deviation of an asset’s
returns from their mean. Figure 1.1 shows two normal curves. Both have the same
mean but the dotted line shows a greater dispersion than the continuous line. These
two curves also illustrate that volatility indicates the range of a return’s movement.
Large values of volatility mean that returns fluctuate in a wide range-large risk. The
most common measure of dispersion is the standard deviation of a random variable.
Investopedia defines volatility as, “A statistical measure of the dispersion of returns
for a given security or market index. Volatility can either be measured by using the
standard deviation or variance between returns from that same security or market
index. Commonly, the higher the volatility, the riskier the security”.
In other words, volatility refers to the amount of uncertainty or risk about the
size of changes in a security's value. A higher volatility means that a security's value
can potentially be spread out over a larger range of values. This means that the price
of the security can change dramatically over a short time period in either direction. A
lower volatility means that a security's value does not fluctuate dramatically, but
changes in value at a steady pace over a period of time (Pandian, 2009).
In Wikipedia, volatility most frequently refers to the standard deviation of the
continuously compounded returns of a financial instrument with a specific time
horizon. It is often used to quantify the risk of the instrument over that time period.
Volatility is typically expressed in annualized terms, and it may either be an absolute
number ($5) or a fraction of the mean (5%). Volatility can be traded directly in today's
markets through options and variance swaps.
 An important aspect of volatility is its emphasis on the variability, rather than
the direction of price movement. For instance the price movement could be upward,
downward or flat, but, in all the three cases, the fluctuations in the price could be
nearly the same despite the direction of the trend. Hence, the variability of price
changes, i.e. the volatility would almost be the same in all three cases (Singh, 2008).
Volatility estimation is important for several reasons and for different people
in the market. Pricing of securities is supposed to be dependent on volatility of each
asset. Mature market/developed markets have lower volatile but they continue to
provide high returns over the long period of time. Amongst emerging economies all
countries except India and China exhibited low returns (sometimes negative returns)
with high volatility (Porwal and Gupta, 2006). India with long history and China with
short history, both provide as high a return as the US and the UK market could
provide but the volatility in both countries is higher.
1.2 SIGNIFICANCE OF VOLATILITY
Volatility represents risk and is a great concern for anyone who is dealing with
money or investing in the stock market or any other financial instruments. So, the
issues of volatility have become increasingly important in recent times to financial
practitioners, market participants, retail investors, regulators and researchers.
Volatility is a matter of concern for market participants for the simple reason
that as an investor one would like to know how much volatility or risk, he or she is
exposed to, as more volatile a stock is, the more risky it is and knowing the volatility
of a stock provides some idea about what possible range of values it will take on some
future date and can make informed decisions on his investments. Nonetheless, it is
hard to predict with any certainty the price of a volatile stock. In general, people
dislike risk and would like to have less risk or no risk while investing.
Secondly, a volatile stock market is a serious concern for policy-makers
because instability of the stock market creates uncertainty and thus adversely affects
growth prospects. Alternatively, policy-makers may feel that increased stock volatility
threatens the viability of financial institutions and the smooth functioning of financial
markets.
Thirdly, volatility is a matter of concern for regulators. The volatility of the
market influences the functioning of the capital markets. Excess volatility prevailing
in the market drives away small investors from the market. Beside this, it may strain
the market clearing and settlement obligations leading to the investor’s loss of
confidence, which in turn reduces participation and liquidity of market.
Fourthly, the price volatility of securities has consequences for firms’
decisions on how much capital to issue, type of instrument to be used and when to
issue.
But the moot question is whether variation or fluctuation in the price of an asset
or volatility is bad?
Volatility has two aspects. To most economists, volatility results from the
arrival of new information in the market. Market participants receive new information
and reassess the true value of asset being traded in the market continuously. In an
efficient market, the price of the traded asset quickly adjusts to reflect this new
information. One result of this process is volatility. Thus, volatility is an evidence of a
properly functioning and informationally efficient market (Narayan, 2006). In this
sense, volatility is good, not bad. Other positive aspect is that one can make more
money if the market moves as per one’s expectations. In fact, an option trader will
gain only when the underlying asset is volatile. In that case, there is chance of out-of-
market (a call option whose strike price is higher than the market price of the
underlying security, or a put option whose strike price is lower than the market price
of the underlying security) option becoming in-the-money (Situation in which an
option’s strike price is below the current market price of the underlie (for a call
option) or above the current market price of the underlie (for a put option). Such an
option has intrinsic value. However, one can lose money if the market does not move
as per one’s expectations.
Nonetheless, volatility, which does not appear to be accompanied by any
important news about the firm or market as whole could be harmful and undesirable.
Stock return volatility hinders economic performance through consumer spending
(Garner, 1988). Stock return volatility affects business investment spending (Gertler
and Hubbard, 1989). Further, the extreme volatility could disrupt the smooth
functioning of the financial system, and lead to structural and regulatory changes.
The volatility of the market influences the functioning of the capital markets.
Excess volatility prevailing in the market drives away small investors from the
market. Besides this, it may strain the market clearing and settlement obligations
leading to the investor’s loss of confidence, which in turn reduces participation and
liquidity of the market.
Volatility also has implications for real economic activity. Capital markets
offer a forum to the business community: what projects are likely to succeed, what
technologies are likely to flourish, and what products consumers are likely to
purchase. If security prices reflect these views accurately, then they give useful
signals to corporate managers and business entities who are trying to maximize the
value of their firms. However, if the prices really contain large systematic errors,
managers of business firms who use these price signals to make decisions are, in fact,
responding to noise only. Thus, excess volatility or “noise”, which does not appear to
be accompanied by any important news about the firm or market as whole undermines
the usefulness of stock prices as “signal” about the true value of a firm. Other effect
of volatility is a large amount of wealth of households has been eroded. Investors may
equate higher volatility with greater risk and may alter their investment decisions due
to increased volatility.
The importance of volatility is that it has the single biggest effect of the
amount of extrinsic value in an option's price. When volatility goes up, the extrinsic
value of both the calls and the puts increases. This makes all the option prices more
expensive. When volatility goes down, the extrinsic value of both the calls and the
puts decreases. This makes all of the option prices less expensive.
1.3 INTER-DAY OR INTRA-DAY VOLATILITY
1.3.1 Inter-day Volatility: The variation in share price return between the two
trading days is called inter-day volatility. Inter-day volatility is computed by close-to-
close and open-to-open value of any index level on a daily basis. Standard deviation is
used to calculate inter-day volatility (Porwal and Gupta, 2006).
1.3.1.1 Close-to-Close Volatility: For computing close-to-close volatility, the closing
values of the Nifty and Sensex have been taken. Close-to-close volatility (standard
estimation volatility) is measured with the following formula:
-
s = (1 / n - 1)å (rt - r ) 2

Where,
n = The number of trading days
rt = Close-to-close return (in natural log)
-
r = Average of the close-to-close return.
1.3.1.2 Open-to-Open Volatility: Open-to-open volatility is considered necessary for
many market participants because opening prices of shares and the index value reflect
any positive or negative information that arrives after the close of the market and
before the start of the next day’s trading .The following formula is used to calculate
open-to-open volatility:
-
s = (1 / n - 1)å (rt - r ) 2

Where,
n = The number of trading days
rt = Open-to-open return (in natural log)
-
r = Average of the open-to-open return.
Inter-day volatility takes into account only close-to-close and open-to-open index
value and it is measured by standard deviation of returns.
1.3.2 Intra-day Volatility: The variation in share price return within the trading day
is called intra-day volatility. It indicates how the indices and shares behave in a
particular day. Intra-day volatility is calculated with the help of Parkinson model and
Garman & Klass model.
1.3.2.1 Parkinson Model: As per Parkinson (1980) model, high-low volatility is
calculated with the following formula:

s = k 1 / nå log( H t / Lt ) 2

Where,
σ = High–Low volatility
k = 0.601
Ht = High price on the day
Lt = Low price on the day
n = Number of trading days.
1.3.2.2 Garman and Klass Model: This model is used to calculate the open-close
volatility. The formula given by Garman and Klass (1980) in their model takes the
following form:

s = 1 / nå (1 / 2)[log( H t / Lt ]2 - [2 log( 2) - 1][log(C t / Ot )]2

Where,
Ht = High price on the day
Lt = Low price on the day
Ct = Closing price on the day
Ot = Opening price on the day
n = Number of trading days
σ = Intra-day volatility for the period.
1.4 STATISTICAL MODEL OF STOCK MARKET VOLATILITY
It is generally said stock market volatility is predictable. This observation has
important implications for asset pricing and portfolio management. Investors seeking
to avoid risk, for example, may choose to adjust their portfolios by reducing their
commitments to assets whose volatilities are predicted to increase or by using more
sophisticated dynamic diversification approaches to hedge predicted volatility
increases. In a market in which such strategies operate, equilibrium asset prices
should respond to forecasts of volatility, as well as to the risk aversion of investors.
This is particularly true of the markets for derivative assets such as options and swaps,
where the volatility of the underlying asset has a profound effect on the value of the
derivative.
As will become clear, a prediction of high volatility is really just a prediction
of high variance - a prediction that the potential size of a price move is great. Thus,
even perfect predictability of variances does not mean perfect predictability of the size
of market moves or of their direction. Volatility forecasting is a little like predicting
whether it will rain: You can be correct in predicting the probability of rain, but still
have no rain. Volatility clustering is one of the oldest noted characteristics of
financial data. It tells us something about the predictability of volatility. If large
changes in financial markets tend to be followed by more large changes, in either
direction, then volatility must be predictably high after large changes. This is, in fact,
how traders typically predict volatility. They measure standard deviations over
various periods and use what they judge to be the most appropriate moving average to
predict volatility. Some adjust standard deviations to reflect recent events, recognizing
that these may contain additional information useful in predicting volatility. Traders
who deal in longer-lived assets (long-lived assets are usually those assets which are
not consumed during the normal course of business, e.g. land and building), however,
may believe that volatility in the distant future is insensitive to current information. It
is possible that better volatility forecasts in either the short or long run could lead to
better estimates of fundamental asset values. It remains to be seen whether the market
already reflects the best available forecasts (Engle, 1993).
There are broadly four possible approaches for estimating and forecasting
volatility. These are: Historical Volatility Models, Implied Volatility Models, Extreme
Value Estimators, and Conditional Volatility Models.
1.4.1 Historical Volatility Models: Volatility is usually an inherently historical
measure of risk, based on the estimated sample standard deviation of some time series
of observed returns on assets and liabilities. This is the simplest model for capturing
the volatility and is widely used. It simply involves calculating the variance or
standard deviation of returns over some past period. It is a total risk measure that
captures both idiosyncratic as well as systematic risk. Standard deviation measures
how widely values (closing prices for instance) are dispersed from the average.
Dispersion is the difference between the actual value (closing price) and the average
value (mean closing price). The larger the difference between the closing prices and
the average price, the higher the standard deviation and the higher the volatility. The
closer the closing prices are to the average price, the lower the standard deviation and
the lower the volatility. It is a relative measure, i.e., standard deviation of stock
returns in one period can be compared with standard deviation of another period to
understand which period has been more volatile. This measure is then used as the
volatility forecast for the future period (Srivastava and Jain, 2006).
1.4.2 Implied Volatility Models: A less well-known, but more valuable measure is
implied volatility. Implied volatility is a value derived from the option's price. This
measure is the result of an important fact about derivatives: the price of the derivative
along with the price of the underlying security produces two observations of the
security’s price. It indicated what the market's perception of the volatility of the stock
or underlying will be during the future life of the contract. A stock that has a wide
trading range (moved around a lot) is said to have a high volatility. A stock that has a
narrow trading range (does not move around much) is said to have a low volatility.
Arbitrageurs have used this fact to profit by determining whether a security is
improperly priced relative to its derivative (Mullins, 2000). Students of the financial
markets can use the information provided by a security’s observed prices along with
the security’s observed derivative prices to generate important information. This
measure uses information available from the derivatives of a security and compares it
with the price of the underlying security. Greater the deviations of one price from the
other, greater is the implied volatility of the concerned security. Another way to look
at it is that actual volatility reflects what happened in past, whereas implied volatility
reflects what option traders expect will happen in the future (Schwert, 1989).
1.4.3 Extreme Value Estimators: These estimators are similar to traditional
estimators except that these also incorporate high and low prices observed unlike
traditional estimators which are based on closing prices of the asset (Pandey, 2005).
1.4.4 Conditional Volatility Models: Conditional Volatility Models
(ARCH/GARCH), unlike the traditional or extreme value estimators, take into
account the time-varying nature of volatility. The ARCH and the GARCH models
assume conditional heteroscedasticity with homoscedastic unconditional error
variance. That is, the changes in variance are a function of the realizations of
preceding errors and these changes represent temporary and random departures from a
constant unconditional variance. The advantage of GARCH model is that it captures
the tendency in financial data for volatility clustering. It, therefore, enables us to make
the connection between information and volatility explicit since any change in the rate
of informational arrival to the market will change the volatility in the market (Pandey,
2005).
1.5 FACTORS AFFECTING STOCK MARKET VOLATILITY
Broadly, the factors which result in volatility can be classified into two
categories: endogenous and exogenous. Endogenous factors are those, which emerge
from different fields like corporate, economy, and politics within the country. These
factors are of two types, micro and macro. Micro factors are specific, like dividend
decisions, major expansion plans, and receiving of big contracts, earning per share,
company size and book value per share have significant impact upon the value of the
stock of that company. Macro level factors affect the whole economic structure of the
economy, and thereby, the behaviour of the stock market. The impact of these factors
clearly gets reflected in the stock market in terms of volatility. These factors include
tax system, interest rate, inflation rate, agriculture and industrial production, bank,
GDP, Government expenditure, foreign institutional investment, the exchange rate,
union budget, imports growth rate, current account deficit, money supply and foreign
currency reserves. Not necessarily, these macro level factors will affect all securities
in the same way and with the same degree. They have a variety of degree impact upon
different securities. The other factors, which cause volatility, are exogenous. The
influence of these factors comes from outside the country. With the integration of
different economies in globalized world, these factors are increasingly emerging and
occupying prominent place with significant impact on economy. Generally, they are
macro in nature. They have become prominent in Indian market with the integration
of economy with the international market. The impact of crude oil price in
international market and changing monetary variables of trading countries are clearly
reflected in Indian stock market. From the index, one cannot conclude, where the
market will stand in near future. Volatility of the stock market is the response to
tangible and intangible market events.
“The interpretation of daily stock price movements as reaction to
announcements of economic events is commonplace in the media. Commentators
often report that stock prices fell because of disappointing unemployment figures or
rose because of encouraging news on the inflation front” (Roley, 1985).
There are number of factors which result in either rise or fall of stock prices or
in other words lead to volatility.
1.5.1 Demand and Supply: One of the main factors that bring about short-term
oscillations in the share prices is the change in demand and supply of a particular
share in the stock market. An increase in its demand or decrease in its supply would
always tend to raise the price and vice-versa. If at any particular time or day the
demand for particular scrip is greater than its supply, the dealers would run short of
stock and would begin demanding a higher price. On the other hand, if there are more
orders to sell rather than to buy, its price would go down. However, it should be borne
in mind in that the supply of shares of a particular company cannot be immediately
increased with a change in price, though the stock available in the market at a
particular time may vary to a little extent (Garg, 1950).
1.5.2 Interest Rates: These play a major role in determining stock market trends. A
decline in short- term rate of interest tends to increase the speculators’ activity as
speculators are anxious to take advantage of the lower rates and borrow money to
invest in securities, yielding a better return. When money is cheap and plentiful,
shares receive support and rise in price and vice versa. In theory, the relationship
between interest rates and stock prices is negative. This is due to the cash flow
discounting model according to which, present values of stocks are calculated by
discounting the future cash flows at a discount rate. If the discount rate increases, then
present values of stocks decline and vice versa. This discount rate is a risk adjusted
required rate of return and equal to the level of interest rates in the economy.
Therefore, an increase in interest rates lowers present values of stocks directly. Even a
relatively small rise in interest rates can have a major effect on present values if it is
spread out over several years. In addition, rising interest rates reduce cash flows by
reducing the profitability of firms. Due to these two reasons, present values of stocks
decline and so do current stock prices. The inverse holds true as well (Apergis and
Eleftheriou, 2002).
Apart from the above theoretical reason, there are few reasons, which account
for the negative relationship between interest rates and stock prices. First, interest
rates are risk free returns on bonds and as interest rates on bonds rise, bonds become
more attractive and stocks less attractive. Consequently, there is a change in the asset
allocation in favour of bonds rather than stocks. This moves funds from the stock
market to the bond market, which invariably increases the demand for bonds and
reduces the demand for stocks. As a result, the prices of stocks fall. The opposite is
true when interest rates fall and funds are shifted from the bond market to the stock
market. Second, corporate profitability is hit because of increase in interest rates in
two ways: (i) companies earnings net of interest rates fall; and (ii) consumers’
demand for the products decreases, they pay more to borrow money. As the
profitability decreases stock prices decline and vice versa. Third, if interest rates
increase then investors’ expectations about the economy and company earnings,
which drive the stock market, turn negative. This pushes stock prices down and the
reverse is true as well (Chakradhara, 2008).
The effects of interest rates changes on a stock’s intrinsic value are more
complex than outlined earlier because of the existence of other economic variables
that interact with interest rates in determining a stock’s value. In addition, if the
inflation rate is quite high and real interest rates do not exist, then the investors are
unlikely to move their funds from the stock market to the bond market in response to
an increase in interest rates. Hence, the negative relationship between interest rates
and stock prices is not necessarily true. The relationship can also be positive due to
the following reasons. First, if interest rates increase in response to the economy
growing too rapidly then corporate earnings should also be growing rapidly and so
should stock prices. Second, higher interest rates suggest higher anticipated inflation.
This leads to a likely increase in corporate pricing power because of which higher
growth rates of earnings per share are witnessed by firms. Therefore, when the
discount factor is increased in the stock valuation formula, the earnings per share are
affected and increased. This implies that lower stock prices are not necessarily
warranted (Durre and Giot, 2005). Third, a positive relationship can be explained in
terms of a changing risk premium. For example, a drop in interest rates could be the
result of increased risk or/and precautionary saving as investors move away from
risky assets such as stocks towards less risky assets like bonds (Barsky, 1989).
However, it is important to note that although the negative relationship between
interest rates and stock prices is not automatic or perfect, in the long run, it is
unavoidable. The above discussion reveals that the relationship between interest rates
and stock prices can either be positive or negative.
1.5.3 Political Conditions: The stock market is one of the most sensitive market and
political development or changes in the political set up affect the share prices. The
changes in the power or party structure or political leaders and personalities at the
centre or states or even changes in their cabinets may bring about changes in share
prices, as operators in the stock market are very quick in interpreting the
consequences of such developments. The share market is hyper-sensitive to these
changes that even a speech by a statesman at a particular time might affect share
prices so adversely that within a few hours many a dealers suffer a huge loss and few
might even collapse.
1.5.4 Globalisation: It has also an important influence on share prices. Bullish and
bearish movements in an economically big country, like U.S.A. and Japan, tend to
produce similar movements in the rest of world, although the “fundamental”
economic factors at the moment do not seem to warrant them. Markets anticipate that,
sooner or later, the real economy would be affected in a similar fashion, in the rest of
the world (Chaudhuri, 2007).
1.5.5 Manipulations and Rumours: Manipulation in relation to stock market
question is difficult to define. It simply conveys the idea of artificially influencing the
prices. Wash sales and match orders are the example of such manipulations. Under
wash sales, fictitious sales are made by one party to the other with a view to raising
the prices of a security or to make it more attractive. One party through manipulations
arranges with the other to take the stock, when offered for sale at the inflated prices.
Such actions arouse sufficient interest in the shares and may cause many unknowing
parties to purchase shares at inflated prices. But such sales are prohibited by the stock
exchanges.
Match orders, similarly refer to the practice of using two or more brokers, one
to buy and the other to sell the same stock at the same time and thus cause prices to
rise higher or decline further. In such a case the same man is purchasing and selling
through the agency of two brokers, who are not aware of the secret of the transactions
and seem to be entirely ignorant of the fact that their client has given opposite, but
corresponding orders to other brokers. In this way, the dealer may be able to fulfil his
objectives, when the desired price level has been stabilized (Dixit, 1986).
A stock market is influenced to a great extent by rumours of all kinds. The
bulls and the bears in their own interest spread all sorts of rumours, baseless or
otherwise and try to bring the market in their own favour. Sometimes these rumours
prove to be an intelligent anticipation of events and on other they represent the
leakage of certain information. In most cases, they are circulated by persons to suit
their own ends and usually it is more difficult to trace their origin. It is evident that the
markets saw to and fro not in response to facts and developments, but in response to
khabar true or untrue, and slightly true and largely untrue. Bear-Bull fight in the heart
of the exchange ring, will relay periodically such gossip has caused gyrations in prices
and changes in market sentiments (Sonpal, 2006).
1.5.6 Trade Cycles: In a period of depression, the tendency to dullness prevails in all
spheres of the market and there is all-round severe curtailment of production. The
pessimistic outlook over the industry in general or any industry in particular brings
about a general fall in the prices of securities, as many dealers, who are not financially
strong are faced to sell securities, because of losses in their regular business. On the
one hand, during a boom, prices of almost all securities rise. A rise in price tends to
coincide with the period of business prosperity and tends to a rise in industrial profits,
which as a consequence brings about a rise in share prices. At the same time, an
increase in the price of commodities used as raw materials would tend to bring a fall
in share prices, unless it happens to coincide with a rise in the price of finished
products. In a period of rising prices, the costs of labour equipment and maintenance
increase resulting in the possibility of higher profits being lessened which might
temporarily bring about a setback in share prices. Traders on the security market keep
a constant watch on the commodity markets and their own market attitude is
determined to a certain extent by the changes in the shares of industrial companies
(Sorab and Caroline, 1990).
1.5.7 Technical Market Position: Share prices, to a great extent, depend on the
technical position of the market. At a particular moment, when share prices in general
are stable, its price is likely to speculative interest in particular share, its price is likely
to start rising, unless it is counteracted by other powerful factors. When the market
has a tendency to rise, a number of bull operators come forward and make purchases
in the hope of further rise in prices, even beyond their capacity. A slight decline in the
price would force these operators to sell their shares in order to limit their losses to an
amount they are able to bear. Such sales would bring about a further depression in
prices, and as such situation arises, the market is said to be technically weak (Garg,
1950).
Whenever prices have risen to their peak levels and the market is not very
strong, on slight unfavourable developments, the market falls to its bottom. When it is
expected that a particular happening would push up the prices of particular
share/shares to rise, but sometimes when the event actually happens, the prices instead
of rising, fall. In the share market, it is a truism that operators are more interested in
anticipation than in the event. It is the thrill of uncertainty that causes the wrangles
between bulls and bears (Dixit, 1986).
1.5.8 Inflation: It is another influential factor that affects the motion of stock prices.
Jaffe and Mandelker, Feldstein, Fama, and Summers attempted to explain this
anomalous reported by various studies.
Unexpected increases in inflation may provoke government or central bank
reaction in the form of changes in fiscal or monetary policy or both. For example,
government may impose price controls or change in tariff rates which might adversely
affect the profitability of firms. The central bank may resort to open market operations
to contain the expansion of money supply pushing up the interest rates in the process.
The rise in interest rates may increase the interest cost of working capital in the short
run and adversely affect the cash flow in the long run as firms resort to cuts in interest
sensitive capital expenditures. This expectation of government or central Bank’s
reaction may be the reason for the response of stock prices which is referred to as
information effect (Jaffe and Mandelker, 1976). Feldstein (1980) revealed that there is
inverse relation between higher inflation and lower share prices. Often inappropriate
monetary and credit policies are pursued to contain inflation, as in India, with the
result that artificial squeeze on money, which create hardships for industry and
business and distort the financial picture on the stock market. In other words, rise in
inflation leads to decrease in real after tax profits and hence share prices-which are
present discounted values (PDVs) of future after tax earnings of firms-decline.
Summers (1981) brought out that increased inflation raises the expected return on
alternative assets such as real physical assets (e.g. owner-occupied housing).Investors
make changes in their portfolios by shifting out of equity holdings and investing the
funds released in the process in other assets. Share prices decline in response to these
portfolio adjustments by investors. Fama (1981) hypothesizes that the negative
relation between real stock returns and inflation is proxing for the positive
relationship between stock returns and real variables which are more fundamental
determinants of equity values. He further argued that the observed negative
relationship between stock returns and inflation is spurious and induced by negative
relationship between inflation and real activity. This hypothesis is known as Fama’s
proxy hypothesis.
Hence, it is observed that there had been a strong inverse correlation between
low inflation and valuations. This is because low inflation propels high multiples, and
high inflation drives low multiples.
1.5.9 Public Opinion and Press Publicity: Share price movements mainly depend on
public opinion, i.e., what people think about the present or future of a particular
company. Public opinion is often created by the press publicity. At one time one scrip
is favoured, while at another the other. As a result of the public opinion often there
arises a sudden and increasing demand for a security, which on account of previous
ill-fervour or lowness of price has been neglected and this would raise its price in
proportion to the new demand created.
The power of the press exercises a great influence, not only on the minds of
the speculators and investors, but also on the public in general. Practically, all
newspapers and commercial and economic journals devote a special column to the
share market reviews, which are looked upon by the dealers with great impatience, as
they all contribute towards influencing the share prices through change in public
opinion. Practical tips appear, indicating whether a particular security is overvalued
and should be sold or otherwise, and if a reviewer has established a reputation in the
market circles, his opinion affects the price movements to a great extent (Singh,
2008).
1.5.10 Foreign Institutional Investors: Stock markets in India were opened to
foreign capital flows in 1992. Since then, their investments into Indian equity market
have grown by leaps and bounds and there is widespread belief that institutional
investors particularly the Foreign Institutional Investors (FIIs) play a major role in the
movements of the leading Indian stock indices. It improves the liquidity of the stock
market in an emerging market. Liquidity is enhanced due to the fact that the entry of
foreign investors makes it easier to find buyers and sellers. On the other hand,
institutions are supposed to move stock prices away from fundamentals and thereby
induce stock returns autocorrelation and increase returns volatility. Herding, Positive
feedback trading and Contagion are the main arguments put forward for the
destabilizing impact on stock prices induced by institutional investors (Mazumdar,
2004).
Therefore, the first channel through which capital inflows cause volatility in
the stock market is that of ‘Positive feedback trading’. Positive feedback trading or
‘trend behaviour’ refers to tendency among fund managers to buy ‘winner’ stocks and
selling ‘loser’ stocks. It describes the strategy of rushing in when the markets are
booming and rushing out when the markets are on the decline. Batra (2003) finds
strong evidence that FIIs have been positive feedback investors at the aggregate level
on daily basis. Investors can be positive feedback traders for rational reasons or
because of behavioural biases. Investors with such strategies are often viewed to be
destabilizing because their sales lead the market to fall further and their purchases
increase prices further. Besides contributing to the volatility of stock returns, it is
argued that such trading leads to destabilizing capital flows. This is because equity
investors rush into countries whose stock markets are booming and flee from
countries whose stock markets are falling (Bohl and Brzeszczynski, 2005).
The second channel through which capital inflow causes volatility in the stock
market is herding mentality. Herding behaviour is defined as the tendency of fund
managers and investors to follow other fund managers trading behaviour, ignoring
their own information. In India, Batra (2003) found that foreign investors have a
tendency to herd on the equity market.
The third channel through which capital inflow causes stock market volatility
is through contagion effect. Contagion is best defined as a significant increase in cross
linkages after a shock to an individual country (or a group of countries). Fund
managers often use contagion strategies, i.e., they sell assets in one country when a
crisis hits another country in the same region. The contagion channel is an extension
of the herd behaviour of fund managers. While herding attracts funds to one region of
the world, contagion precipitates exit of fund manager from the same region in times
of crisis (Dornbusch et al., 2000).
1.5.11 The Information Boom: The speed of media (measured by the time required
to send news from site to the viewer) has gone up tremendously in recent times.
Hoards of Business news channel (Star News, Zee News, CNBC Asia, Jain TV, etc.)
are providing information on the movements of stock round the clock. With screen
based trading the information is also available with investors. The news feed provided
by Reuter and Bloomberg keep the investor updated every minute. Such increased
reporting of stock movements generally increases the demand for stocks. This has
resulted in markets adjusting to such information faster than before which in turn
increase market volatility (Bohart, 2007).
1.5.12 Sentiment: It has an all pervading influence on the stock price movements.
When it is a dull day in the stock exchange and the tendency is downward, buyers
become panicky and refrain from buying, otherwise, it is beyond one’s
comprehension as to what happened with the company overnight. Due to this
downward tendency more sellers than buyers are noticed and this state of affairs
further brings down the prices and a new low level of price is created. Before the
market takes a turn for the better, a transition period appears and wise investors with
liquidity money available with them come into buy shares and without any reason, the
sentiment is changed for the better and prices begin to move up (Dixit, 1986).
1.5.13 Psychological Issues on Stock Prices: Stock prices are also greatly influenced
by human behaviour. Greed is one trait that can cause stock prices to increase more
than it should. New information can elicit a frantic market, may cause an increase in
prices, and may make investors disregard rational valuation, preferring instead to buy
the stock to ensure they are not left behind. Fear can cause significant decreases in
stock prices when investors rush for the exit in an effort to avoid losses. While
expressing his views on the subject Keynes (1936) said, “It might have been supposed
that competition between expert professionals, possessing judgement and knowledge
beyond that of average private investor, would correct the vagaries of the ignorant
individual left to himself. It happens, however, that they are concerned, not with what
an investment is really worth to a man who buys it “for keeps”, but what the market
will value it at, under the influence of mass psychology, three months or a year
hence.” Hence share prices are moved by mass psychology. It is not the psychology of
millions of people, including the so-called experts, independently: it is largely a
question of mass psychology (Simha, 2002).
1.5.14 Expectations and Foresight: Expectations and foresight of investors as well
speculators determine the magnitude of price fluctuations to a large extent. If market
participants anticipate changes in either fundamental factors or other factors correctly,
and if the change or anticipated change comes about gradually, the prices move in a
smooth fashion from one point of equilibrium to another. On the contrary, when the
anticipations prove to be either too optimistic or too pessimistic, or the changes in
these factors or anticipations about them undergo a sudden change, the prices move
erratically, rather than move in a smooth fashion resulting in greater price fluctuations
(Black, 1986).
1.5.15 The Internet Myth: Internet has made this world a global entity where
potential is immense for business, if done in the smartest way. The importance of
concept or idea made Internet a highly skill driven business and also highly volatile.
A new concept can outplace a leader within no time. This whimsical nature of Internet
Business was totally ignored by the stock markets globally. The positives that were
highlighted by media totally outnumbered the pitfalls. The hype about business
prospects that was created was not backed by a sustainable financial analysis. Thus,
companies were highly over valued on the basis of future business prospects though
they were accumulating huge losses. Hence, the innocent investor being ignorant of
the darker side invested heavily leading to excessive demand of Internet Stocks
(Chowhan and Shukla, 2007).
1.5.16 State Policy: In an economy like India, which is committed to democratic
socialism, planned development and state control of regulation, state policy plays a
vital role in the stock markets. State measures as reflected in legislation, budgets,
industrial policy, foreign trade strategy, foreign aid and investment prospects, taxation
proposals, custom duties, fiscal measures, policy towards multinationals and foreign
investment, etc. affect the share prices to a great extent.
1.5.17 Operators watch the presentation of the Central Budget with great anxiety. An
imposition of a duty or an enhancement of taxes would affect share prices according
to its repercussions on the minds of the investors. For example, the bears try to
convince themselves and others that the budget cannot be good as is made out. The
bulls maintain that the budget is bound to be favourable and buy shares themselves
and persuade their friends to buy also. Bears and their friends are thus pitted against
the bulls and their friends. Their gamble imparts vivacity and vigour to the stock
markets. Prices move upward down, often times wildly. Whichever side has greater
confidence in its expectations and greater guts in its operations succeeds in
influencing the prices in direction favourable to itself (Thomas and Shah, 2002).
1.5.18 The Feedback Effect: In feedback theory, the stock price increase forms a
vicious circle whereby the initial increase (decrease) propels further price increase
(decrease). This can be explained by the fact that an increase in the stock prices leads
to a better sentiment for that stock which increases the demand and thus the price.
This cycle continues increasing the stock price more than what it would have under
the Efficient Market Hypothesis (EMH). Though this may seem quite perfect but this
leads to a spiraling effect and increased volatility in stock markets. A test was carried
out to check the difference in volatility of stocks while they are rising as opposed to
their fall. It is also seen that these feedback loops have different intensities during a
Bull run and a Bear run. It was seen that the price volatility was more when the stock
was falling as compared to when it was rising which shows that the feedback was
more during a bear run (Kundu, 2007).
1.5.19 The number of Speculators in relation to other traders also influences the
extent of fluctuations. The traditional role of a speculator is to act as a buyer when
there is excess supply and as a seller when there is excess demand. On the contrary, if
speculators choose to buy, when there is excess demand, and sell, when there is
excess supply, the demand supply imbalance gets further widened and as a result, the
extent of price fluctuations would be greater. If number of speculators in relation to
other traders is more, speculators, instead of mitigating the magnitude of price
change, influence the direction of price change (Reddy, 1996).
1.5.20 Another obvious reason for market volatility is Technology. This includes
more timely information dissemination, improved technology to make trades and
more kinds of financial instruments. The faster information is disseminated, the
quicker markets can react to both negative and positive news. Improved trading
technology makes it easier to take advantage of arbitrage opportunities, and the
resulting price alignment arbitrage causes. Finally, more kinds of financial
instruments allow investors more opportunity to move their money to different kinds
of investment positions when conditions change (Dixit, 1986).
1.5.21 Another factor operating in the share market is Insider Trading by promoters
and executives of companies. When this assumes a large dimension, it is
destabilizing; it distorts the market. Furthermore, not always is the published data on
performance of reliable companies. There is much window-dressing. Accounts are
also falsified deliberately, to mislead the investor to give a rosy picture of a
company’s financial position. Auditors collude with the company promoters and
executives. Recent experience shows that these evils are present in the highly
developed countries too, with fairly good laws to regulate the functioning of
companies and investment institutions in the interest of the investor (Simha, 2002).
1.5.22 Other Factors: In addition to the above mentioned factors there are number of
other factors which affect share values to a greater or lesser degree.
1.5.22.1 Wars and Crisis Situation: War is mighty upheaval that brings about
changes in all spheres of business activity and the share market is not free from its
consequences. Share prices change all around to a great extent, when fear, baseless or
otherwise, grips the share market and the international politics displaces business at
the steering wheel (Sorab and Caroline, 1990).
1.5.22.2 Climate for Production and Productivity: Frequent shortages of raw
material and components of production have affected the production adversely which
bring about a fall in share prices. Industrial climate, strikes and lock outs in a
particular industry or industry in general also adversely affect the share prices in that
industry. Inadequate and erratic power supply or coal supply is another constraint to
the production which affects production and share prices adversely. Transport
bottlenecks such as shortage of wagons and trucks disrupt the supply of raw materials
and production is interrupted, thereby causing the share prices to fall. Constraints to
production and productivity adversely affect share prices while incentives restore
confidence of the share markets (Beltratti and Morana, 2004).
1.5.22.3 Arbitrage: It also causes volatility. Arbitrage is the simultaneous or almost
simultaneous buying and selling of an asset to profit from price discrepancies.
Arbitrage causes markets to adjust prices quickly. This has the effect of causing
information to be more quickly assimilated into market prices. This is a curious result
because arbitrage requires no more information than the existence of a price
discrepancy (Sonpal, 2006).
1.5.22.4 Natural Calamities: The natural calamities like floods, droughts due to
failure of monsoons, earthquakes, explosions, devastation and disaster affect the share
prices to a great extent. Even the death of an important shareholder, who holds a
number of shares, would also affect share prices as the holdings of the deceased
person may be sold on the stock market and when such selling would take place on a
large scale, prices in that particular market would fall. Prices in other markets might
also fall in sympathy, but only for a very short period (Sorab and Caroline, 1990).
1.5.22.5 Holidays: The working days preceding a long holiday such as Christmas and
Durga Puja have been noticed as periods of inactivity and more often dull conditions
are found as the operators are in a holiday mood. But during the holidays a large
number of orders accumulate, which are to be transacted on the opening day and
hence a heavy turnover often takes place; and if other conditions are favourable prices
tend to rise (Dutta and Mahapatra, 2008).
1.5.22.6 Technical Influence: Share prices can rise and fall for a variety of technical
reasons that may have nothing to do with the actual outlook for an individual
company or the outlook for the market. It is, for example, a common occurrence for
share prices to drop back after a strong rally. This happens because investors take
profits on some of the shares that have risen in value, protecting their gains just in
case the shares start to slip back. Investors often refer to this as market consolidation
(Dhankhar, 1995).
1.5.22.7 Uncertainty: The movement of stock prices is also affected by a vague
future. Prices do tend to bounce around a bit due to market apprehension and the
unpredictable future. Because of the ambiguity of a company’s future, volatility in
stock prices is possible even without new information (Barua and Varma, 1983).
1.5.22.8 Economic Strength of Market and Peer: Company stocks have the
propensity to track with the market, as well as with their sector or industry
contemporaries. A lot of leading investment firms put significant importance on
overall market and sector movements as major factors involved in the movement of
prices. An example would be when a negative outlook for one stock affects other
similar ones due to mere association with each other, dragging the demand for the
whole sector along the way (Obaidullah, 1992).
1.5.23 Company Specific Factors: The factors such as quality and credibility of
promoters, competence and professionalism of management, policies with regard to
financing, investment and dividend decisions and other various variables like
dividend per share, earning per share company size, and book value of share influence
the security prices of the companies. These have been discussed in detail as follows.
1.5.23.1 Dividend and Earnings: Earnings of a company occupy a supreme position
in determination of the values of industrial shares. It has often been noticed that at
times when the dividend has been announced, the values of the company’s share have
flared up and if the dividend announcement happens to be much more than what was
expected, it further stimulates the prices to a greater extent. Contrary would be the
case if due to some reasons the company’s earnings are going to fall, which will not
enable a company to maintain its former level of dividends. But at times it may be
noted that the prices of certain shares might actually fall when the company in
question has declared a higher dividend than expected. It is because that the
speculators much in advance to the declaration of dividends and prices as a
consequence go up to a very high and artificial level and by the time the dividends are
declared, these prices reach their top limits and it is at that time that the speculators
sell out quickly with a view to collect their profits and this large scale selling might
cause prices to fall down (Bodla and Turan, 2005).
A change in company’s earnings and dividend announcement is, thus,
accompanied by change in share values and any limitation of dividend by any
legislative enactment is likely to bring about a collapse in share values. This actually
happened on the Finance Members pronouncement in the Assembly to the effect that
“Government was considering the question of restricting of the dividends
accompanied by provision of compulsory savings. This had an intimate bearing on
equity shares and affected the morale of the operators and brought about a liquidation
of holdings and as a consequence, price tumbled down (Dutta, 2004).
1.5.23.2 Change in the Capital Structure of Companies: Share prices move up and
down in cyclic motion in conformity with the general movement in prices, as a
company passes through periods of boom and depressions. But this general tendency
is more often counteracted by a change in capital structure of the company, such an
increase in the share capital of the company, issue of shares on bonus terms, issue of
fresh debentures, redemption of debentures, making up of partly paid share fully paid,
reorganizing the rights of different classes of shareholders such as converting deferred
into ordinary and so on. Different schemes of capital reorganisation may affect the
market in different ways. For example, when fresh debentures are issued, it is
regarded as a sign of weakness by the Indian investing public, and operators on the
Stock Exchange feel that in future the company would not be able to maintain its old
level of dividends as much of the money of the company would be utilized in paying
interest to debentures holders. Though at such occasions they forget that very often
flourishing businesses need extra capital to make it more successful and may
ultimately pay higher dividends to the shareholders (Garg, 1950).
On the other hand, the redemption of debentures is usually regarded as a good
sign as the company after paying off its debts would be able to declare higher
dividends as it shall no longer be required to pay interest on debentures and the
amount so saved may be used in increasing the dividends to be distributed to the
shareholders. Thus, at such times share values would show a rising tendency.
1.5.23.3 Change in Ownership: Whenever there happens to be a change in the
ownership and management of a concern its share values might fluctuate. Changes in
the Board of Directors of a company also affect the prices of the shares of that
particular company and may bring about the repercussions of far reaching importance.
The death of responsible and influential member of the Board may cause share value
to fall, particularly so if he himself holds a large number of shares of that company.
Frequent resignations of directors from the Board may also create suspicion in the
minds of the operators regarding the financial stability of the company and cause a
setback in share values (Grewal, 2000).
1.5.23.4 Changes in Share Prices on Issue of Bonus and Rights Shares: The issue
of bonus shares by a company has a bullish effect on its prices. Expectations of a
bonus issue create a climate of optimism and arouse amongst investors hopes of
getting steep capital appreciation and higher dividends. The market looks upon the
issue of bonus shares as an indication of a company’s bright future prospects. These
market expectations are based on sound logic and reasoning. Companies do not
normally issue bonus shares unless they are confident of maintaining the dividend rate
on the expanded equity capital resulting from the bonus issue, and unless they are
reasonably certain that the future expansion of the company justifies an expansion in
its equity base (Gupta, 2006).
Rights shares are generally issued either at par or at a small premium. They
are invariably priced at a level far below the prevailing market price. If rights shares
are issued exclusively to the existing shareholders, and if they are attractively priced
carrying only a low premium, they are generally well received by the market and
exert an upward pressure on the company’s share price. A rights issue presents an
opportunity for the shareholder to increase the size of his shareholding at a relatively
low cost and with no change in his proportionate ownership of the company. The
attractiveness of rights issue also depends upon the reasons for its issue. If the rights
issue is made for the purpose of raising funds for expansion, then it will have
favourable impact on the investment quality and the price of the company’s share. On
the other hand, a rights issue is made for augmenting working capital, or for meeting
unexpected costs, or for tiding over tight credit and money conditions, is not likely to
be well-received by the market as it exposes a company’s financial difficulties (Wei
and Zhang, 2006).
1.5.23.5 Company Profits: The profits earned by the companies tend to affect the
decision of the investors. The companies doing well in their business activities are
likely to attract more investors, thereby resulting in high demand of their shares.
However, the entities not doing well may result in investors selling their shares on the
market. Selling en masse will result in more shares flooding the market and
consequently bringing the price down - an abundance of a commodity leads to price
decline (Chaudhuri and Swarup, 1999).
1.5.23.6 Market Capitalization: The worth of a company should not be assessed
from the price of its stock. It is the market capitalization of the company, rather than
the stock, that is more important. We need to multiply the stock price with the total
number of outstandings in the market to get the market cap of a company and that is
the worth of the company (Malakar and Gupta, 2002).
1.5.23.7 Price/Earning Ratio: Price/Earning ratio or the P/E ratio gives us a fair idea
of how a company's share price compares to its earnings. If the price of the share is
too much lower than the earning of the company, the stock is undervalued and it has
the potential to rise in the near future. On the other hand, if the price of the share is
too much higher than the actual earning of the company, then the stock is said to be
overvalued and the price can fall at any point (Laxmi, 2006).
1.5.23.8 Company News: The way investors interpret news coming out of companies
is also a major influence on share prices. Positive news about a company can increase
buying interest in the market, while a negative press release can ruin the prospects of
a stock. If, for example, a company puts out a warning that business conditions are
tough, shares will often drop in value. If, however, a director buys shares in the firm,
it may be a signal that the company’s prospects are improving.
Hence, various factors causing volatility in stock prices are rising interest
rates, high inflation fuelled by firm global crude oil prices, slow down in the economy
and in corporate earnings, fluctuations in currency markets, sluggish pace of
economic reforms, political instability, crash in assets prices across the board,
political tension and possible terrorist attacks. Market movements can be driven by
political, economic, social and most importantly, psychological factors. Binder and
Merges (2000) identify four determinants of stock market volatility i.e. uncertainty
about the price level, the riskless rate of interest, the risk premium on equity and the
ratio of expected profits to expected revenues. Shiller (1987) revealed that true
investment value of the aggregate stock market changes through three indicators:
changes in dividends, in real interest rates, and in a direct measure of intertemporal
marginal rates of substitution. Kaur (2004) argues that factors which affect long-term
volatility include a company market capitalization, corporate leverage-comprising
financial leverage and operating leverage, personal leverage and the condition of the
economy. Among short-term factors are traded volume, news and noise trading, etc.
and volatility is higher in the case of lower capitalization company stocks. They are
traded at low price and with low frequency of trading as compared to high
capitalization companies. Rao (1997) found that budgets increased the volatility of
stock prices of the market portfolio. Chen et al. (1986) found that macroeconomic
variables like industrial production, the spread between long and short interest rates,
expected and unexpected inflation affect the stock market.
1.6 REGULATORY MEASURES TO CURB STOCK PRICE
VOLATILITY
SEBI has taken certain measures to control the volatility which include margins,
price limits, circuit breakers, and transaction taxes.
1.6.1 Margins: Margins are initial deposits that ensure that traders are well
capitalised to handle their exposure to the stock market. Margins are primarily used to
mitigate default risk and, thereby, systemic risk in the economy. However, margins
also affect market liquidity and price efficiency. To the extent that margins impose
opportunity costs (of locked-up capital), they impose a transaction cost on traders.
Consequently, transaction costs are higher and there is less market liquidity than there
would be otherwise. Moreover, information-based speculators are discouraged due to
the additional transaction cost, and price efficiency in the market suffers. One positive
spin-off from the additional transaction cost is that informationless speculative
activity may also decline. Regulatory authorities hope that this would cause a
reduction in price volatility (Hseih and Merton, 1990).
1.6.2 Price Limits: Price limits are mostly used in futures contracts. They are rarely
used for stocks, the exceptions being the stock markets in India and Japan. Price limits
constrain transactions to occur within a given range centered on the previous day’s
closing price. No trading can take place outside this range. However, the market is not
closed in the sense that one can always trade within the stated range. Price limits help
mitigate default risk by applying a cap on daily price changes. However, price limits
affect information-based speculative activity because they limit the profit potential of
short-lived information. Informationless speculators would also prefer a world
without price limits as it constrains the flexibility of their trading strategies. More
importantly, potential market breakdowns (when price limits are hit) delay price
discovery and market participants, in general, are precluded from entering and exiting
the market at their convenience. This loss of liquidity makes a market with price
limits less attractive. Regulators also see price limits as a mechanism to curb
overreaction to news (Anshuman and Subrahmanyam, 1999).
1.6.3 Circuit Breakers: Circuit breakers are primarily used on a stock index. Order-
imbalance circuit breakers are triggered when markets cannot clear without significant
price changes. Volume-induced circuit breakers are used to mitigate system failure
due to operational backlogs. Finally, price-induced circuit breakers are triggered when
price changes go outside a stated range. The influence of circuit breakers is similar to
that of price limits. Unlike price limits, circuit breakers necessarily involve an explicit
trading halt. The basic purpose of circuit breakers is to curb volatility. It is believed
that a trading halt allows traders an opportunity to ‘cool down’ and reassess the
situation in a rational manner (Singh, 2008).
1.6.4 Transaction Taxes: Transaction taxes can also be used to curb volatility. This
tax is aimed at curbing the instincts of ‘wild’ speculators (informationless). However,
since it is impossible to distinguish between the motives of traders, transaction costs
for all traders would increase. This worsens market liquidity and inhibits price
discovery. In contrast to the other measures, transaction taxes may have little bearing
on default risk (Umlauf, 1993).
Theoretically, all four regulatory measures can curtail volatility. Margins and
transaction taxes are better in the sense that they do not cause a market breakdown,
whereas price limits and circuit breakers can cause trading halts. The success of these
measures in reducing price volatility depends on the extent to which informationless
speculative traders dominate the stock markets. Furthermore, the success of these
measures also depends on how noise traders respond to the imposition of a particular
regulatory measure. All the regulatory measures have adverse effect on market
liquidity and price efficiency. In other words, there are tradeoffs involved in
controlling volatility, affecting liquidity, and inducing price efficiency.
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